Galleon, insider trading probes could slam hedge funds and stock market

Packed with wiretaps, snappy dialogue and high-profile characters, the insider trading case surrounding the Galleon Group has played out like a B movie so far.

But as the investigation grows to include more top executives from some of the world's most blue-chip companies, investors should take a more sober look at what the fallout for the broader market could be. A broad crackdown on the $2 trillion hedge fund industry could be in the works and that would ravage an already fragile stock market

On Friday, tech giant IBM (IBM)said that former vice president Robert Moffat was no longer with the company. Prosecutors have said that Moffat – widely seen as a candidate for the CEO position at the venerable IBM – had tipped off an associate of Galleon founder Raj Rajaratnam about an upcoming earnings announcement at partner company Sun Microsystems (JAVA).

Moffat joins a growing roster or senior executives who have recently been sacked from esteemed companies like Intel (INTC) and McKinsey for serving as Rajaratnam's informants. At AMD (AMD), it was none other than former CEO Hector Ruiz who is being implicated in the scandal, raising questions about why the top brass in Corporate America would risk jail time to help a hedge fund manager.

A Culture of Back-Scratching

It's possible that Rajaratnam – charged with insider trading in stocks ranging from Hilton (HLNQ) to Google (GOOG) – was just a particularly skilled networker who happened to build up a Rolodex of top executives. But it's much more likely that a "you scratch my back" culture was simply the norm on Wall Street, and many other giant hedge funds are also in the business of ferreting out sensitive pieces of market-moving information.

Take hedge fund monster SAC Capital, which routinely makes up for as much as three percent of the volume on the New York Stock Exchange and one percent of volume on the Nasdaq. SAC founder and hedge fund juggernaut Steve Cohen is known to lavish Wall Street brokers with massive trading fees – about $150 million a year – and "the torrent of commissions wins Cohen the clout that often makes him privy to trading and analyst information ahead of rivals," BusinessWeek reported in 2003.

"I call Stevie personally when I have any insight or news tidbit on a company," on analyst told the magazine. "I know he'll put the info to use and actually trade off it."

More Dominoes to Fall?

Earlier this week, prosecutors issued a subpoena to a former SAC employee Richard Grodin and the hedge fund he started promptly shutdown. Other terrified hedge fund managers are looking for ways to see if their phones are bugged amid the prospect of wiretaps. Some commentators are turning their attention to SAC itself.

"As the Galleon inquiry expands, we have been fairly certain that the dominoes would start falling," the blog Zerohedge wrote this week. "Whether or not one of these dominoes would be the fund that single-handedly defined the term 'information arbitrage' is still anyone's guess," it wrote in reference to SAC.

A crackdown on the transmission of sensitive information could undermine the very business model of a big swath of the hedge fund industry.

Shoot First, Ask Later

The scrutiny could not come at a worse time for hedge funds. Disappointed by poorer-than-expected performance and high fees, many big pension funds and endowments were already thinking about pulling some of their money from hedge funds. As Galleon discovered, investors blew up the firm in a matter of days following the announcement of an inquiry, even as it repeatedly reassured them about its ample liquidity.

The specter of prosecutions would lead many already skittish investors to flee the hedge funds commitments they have already soured on. As Galleon and Quadrum show, investors tend to shoot first and ask questions later.

A broad squeeze on the massive hedge fund market, meanwhile, would surely be tumultuous for an already fragile market.

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